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[VENTURE CAPITAL]

Question:

EMT 718 FINANCIAL AND ACCOUNTING MANAGEMENT

Why should a firm consider utilizing a venture capitalist? What type of characteristic should the firm consider if they decide to pursue this means of financing?

Answer: Definition of Venture Capital Venture capital refers to money that is invested in companies during the early stages of their development. Such funds may come from wealthy individuals, government or professionally managed venture capital firms.( Gompers, Paul, and Josh Lerner,2004) According to Raphael Amit, James Brander, And Christoph Zott, venture capital can also be defines as generally provides funding to businesses that are in their early stages of development. The main receptors of these funds are small and medium businesses because they are on the rise and have great reach of development compared to already established businesses. Moreover, we can say venture capital is expressed through the acquisition of shares in the capital of the company in the investment, usually through the purchase of shares. It is a way to channel savings by allowing for the lack of self-financing small and medium business. Definition of Venture Capitalist. A venture capitalist is a person who provides equity financing to companies with high growth potential. The money that a venture capitalist invests in a company is called venture capital. Venture capital firms are often limited partnerships that comprise a few venture capitalists. Each venture capital firm manages a venture fund, which is often comprised of a large pool of money. Why should a firm consider utilizing a venture capitalist? For a start-up firm, this frees up important cash flow that might otherwise be needed to service debt. The involvement of high-profile investors may also help increase the credibility of a new business. The main disadvantage to venture capital financing is that the investors become part owners of the business, and thus gain a say in business decisions. The company's founders face strength of their ownership positions and a possible loss of autonomy or control. 1 | FINANCIAL AND ACCOUNTING MANAGEMENT

[VENTURE CAPITAL]

EMT 718 FINANCIAL AND ACCOUNTING MANAGEMENT

Even for business owners willing to make the trade off, venture capital is scarce and often difficult to obtain. Venture capitalists tend to be highly selective in choosing investments. Some will only consider investments in specific technologies, industries, or geographic areas. In fact, the larger venture capital firms typically reject more than 90 percent of the requests for funding that they receive. They evaluate the remaining requests thoroughly, and at considerable expense, before selecting a few that closely match the investors' areas of expertise and offer the best earnings potential. As a result, private equity financing is more likely to be an option for existing businesses with a solid track record and good prospects for future growth than for start-up companies. It is a particularly good choice for fast-growing companies that have few tangible assets to use as collateral for loans. For a business owner, the process of obtaining venture capital begins with a formal proposal. The most important element of this proposal is a detailed business plan describing the company's goals and strategies. The proposal should also include recent financial statements, projections of future growth, a brief history of the company, biographies of key managers, the amount of money requested, and a description of how the funds will be used. Experts recommend that companies seeking equity financing evaluate several venture capital firms before entering into a deal. Managers should also hire professionals to help them understand the terms of the agreement to avoid giving away too much control. On receiving a proposal of interest, a venture capital firm usually follows up with a thorough investigation of the company's investment potential. This process might include analyzing financial statements, interviewing customers and suppliers, and meeting with the management team. If the venture capital firm remains interested following the evaluation phase, it usually responds with a proposal of its own, known as a term sheet. The term sheet acts as a blueprint for the investment deal, with provisions covering such issues as the valuation of the investment, voting rights, and liquidation options. The final terms are decided through negotiations between the business managers and the venture capital firm. One of the most important factors in the negotiation process is agreeing upon the valuation of the business, which determines the amount of equity that is required in exchange for the venture capital (a business with a low valuation must provide a high percentage of equity, and vice versa). As a general rule, venture capital firms seek to control between 30 and 40 percent of equity in the companies in which they invest. This amount allows the venture capital firm to exercise influence without assuming control or eliminating the management team's incentive to grow the business.

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[VENTURE CAPITAL]

EMT 718 FINANCIAL AND ACCOUNTING MANAGEMENT

What type of characteristic should the firm consider if they decide to pursue this means of financing? The literature examining the investment decision of the VC firm has been segmented into two primary parts: (1) the pre-investment perspective; and (2) the post-investment perspective (MacMillan, Zemann, and Narasimha 1987). The pre-investment literature focuses on factors influencing the investment decision of the VC. The post-investment literature, on the other hand, examines any issues related to the VC, entrepreneur, and/or funded firm, after the initial investment of capital. However, to facilitate the development of more specific hypotheses and easier interpretation of findings, researchers have further segmented the VC investment process into multiple stages (e.g., Silver 1985; Tyebjee and Bruno 1984). One such study, Hall (1989), described the VC management process using eight stages: (1) generating a deal flow; (2) proposal screening; (3) proposal assessment; (4) project evaluation; (5) due diligence; (6) deal structuring; (7) venture operations; and (8) cashing out. Of these, our primary focus is on stage six, which involves structuring of the pre-investment deal specifics. In stage six, which follows the "invest or not invest" decision made in stage five, the VCs determine how much funding to deliver, in how many stages to deliver the funding, and how much involvement and control are warranted in the VC-E relationship. Stage six represents the culmination of portions of the previous four stages, including the screening, assessment, evaluation, and due diligence of the proposal/project. Throughout stages two through six, VCs constantly attempt to determine the potential success or failure of a particular venture by evaluating a number of different criteria, including (1) the entrepreneur/team skills and capabilities; (2) product/service attractiveness; (3) market conditions and competition; and (4) potential financial returns (Zacharakis and Meyer 2000). These criteria work together in leading to the fifth stage decision of whether or not to invest, and then to a decision of the amount of capital and involvement that should be invested in a given venture. However, as previously stated, these criteria may differ in their level of significance to the actual decision depending on the stage of the decisionmaking process (Hall and Hofer 1993). Following Zacharakis and Meyer (2000), along with numerous related studies (e.g., MacMillan, Siegel, and Narasimha 1985; MacMillan, Zemann, and Narasimha 1987; Tyebjee and Bruno 1984), the discussion now turns to three key criteria used to determine the level of financing offered by the VC and how the financing should be structured: confidence in the entrepreneur, confidence in the venture, and potential control of the VC over the venture.

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[VENTURE CAPITAL]
Reference

EMT 718 FINANCIAL AND ACCOUNTING MANAGEMENT

Bygrave, W., and J. Timmons (1992). Venture Capital at the Crossroads. Boston, MA: Harvard Business School Press. Bygrave, W. D. (1987). "Syndicated Investments by Venture Capital Firms: A Networking Perspective," Journal of Business Venturing 2, 139-154. Cable, D. M., and S. Shane (1997). "A Prisoner's Dilemma Approach to EntrepreneurVenture Capitalist Relationships," Academy of Management Review 22, 142-176. Carter, R., and H. E. Van Auken (1994). "Venture Capital Firms' Preferences for Projects in Particular Stages of Development," Journal of Small Business Management 32, 60-73. Chan, Y.-S. (1983). "On the Positive Role of Financial Intermediation in Allocations of Venture Capital in a Market with Imperfect Information," Journal of Finance 38, 1543-1561. Choi, Y. R., and D. A. Shepherd (2004). "Entrepreneurs' Decisions to Exploit Opportunities," Journal of Management 30, 377-395. Chrisman, J. J., A. Bauerschmidt, and C. W. Hofer (1998). "The Determinants of New Venture Performance: An Extended Model," Entrepreneurship Theory and Practice 23, 5-29.

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